Answer: This question can get complicated AND expensive. First start with a definition per the IRS;

“Fair market value (FMV) is the price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.”

Source: IRS Publication 561

This is the standard the IRS uses to determine if an item sold or donated by you is valued correctly for income tax purposes. It is also a definition that is so broad that it is wide open to interpretation. The difficulty here, is if the IRS decides your FMV opinion is wrong, you are not only subject to more tax, but penalties to boot. Here are some tips to help defend your FMV in case of an audit.

Understand when it is used

Fair Market Value or FMV is used whenever an item is bought, sold, or donated that has tax consequences. The most common examples are:

Buying or selling your home or other real estate

Buying or selling personal property

Buying or selling business property

Establishing values of other business assets like inventory

Valuing charitable donations of personal goods and property like automobiles

Valuing bartering of services

Valuing transfer of business ownership

Valuing the assets in an estate of a deceased taxpayer

Ideas to defend your FMV determination

Here are some suggestions to help you defend your FMV determinations.

Properly document donations. FMV of non-cash charitable donations is an area that can easily be challenged by the IRS. Ensure your donated items are in good or better condition. Properly document the items donated and keep copies of published valuations from charities like the Salvation Army. Don’t forget to ask for a receipt (confirmation) of your donations.

Donate capital items like automobiles to the correct places. You may use the FMV of a donated automobile but only if the charity you donate the item to will use it themselves, or will provide it to someone who will use it. Websites like Kelley blue book (kbb.com) can help establish the value of your vehicle when you donate it. Otherwise, the FMV of the donated vehicle will be limited to the amount the charity receives when they re-sell it.

Get an appraisal. If you sell a small business, collection, art, or capital asset make sure you have an independent appraisal of the property prior to selling it. While still open to interpretation by the IRS, this appraisal can be a solid basis for defending any differences between your valuation and the IRS.

Keep copies of similar items and transactions. This is especially important if you barter goods and services. If you have a copy of an advertisement for a similar item to the one you sold, it can readily support your FMV claim.

Take photos. The condition of an item is often a key determinate in establishing FMV. It is fair to assume an item has wear and tear when you sell or donate it. Visual documentation can be used to support your claimed amount.

Keep good records. Keep copies of invoices for major purchases. Retain bills for any improvements. Make sure your sale of property includes a dated bill of sale that clearly states transfer of ownership and amount paid for the item.

With proper planning, establishing the fair market value of an item sold or donated, can be done in a reasonably defendable way if ever challenged.